Posts Tagged ‘Federal Reserve’

Everyone has been writing epitaphs for the “end” of QE2, the Federal Reserve’s program to buy $600 billion in Treasury bonds.

In a narrow sense, they are right: the Fed just completed those purchases. What most coverage misses, however, is that the effects of “quantitive easing” depend at least as much on the Fed’s owning the bonds as buying them. The stock matters at least as much as the flow.*

The epitaphs apply only to the buying. The stock–Fed ownership of $600 billion in Treasury bonds–is still with us.

Which brings us to today’s question: What should we call that? To say that QE2 is over leaves the impression that the program is over. It’s not.

One answer would be to expand the definition of QE2 to include the owning as well as the buying. In that case, we’d simply say that QE2 is still in place.

That strikes me as the cleanest solution except for one thing: almost everyone seems to want to believe that QE2 is over. So we need a new name.

To get some inspiration, consider the three stages of traditional monetary policy. You know, the kind where the Federal Reserve moves short-term interest rates up and down:

Cutting rates (easing)

Keeping rates low (accommodation)

Raising rates (tightening)

The Fed’s asset purchases will go through three stages as well:

Buying assets (quantitative easing)

Owning assets (quantitative accommodation)

Selling assets (quantitative tightening)

Stage 1, quantitative easing, just ended. When the Fed someday starts selling, that will clearly be quantitative tightening.

But what about stage 2? The best I can come up with is quantitative accommodation, QA for short.

That doesn’t really flow off the tongue, and better suggestions would be welcome.

For now, though, here’s my recommendation: If you insist on saying that QE2 is over, you should also be saying that QA2 just began.

[W]e subscribe generally to what we call here the stock view of the effects of securities purchases, which—by which I mean that what matters primarily for interest rates, stock prices, and so on is not the pace of ongoing purchase, but rather the size of the portfolio that the Federal Reserve holds. And so, when we complete the program, as you noted, we are going to continue to reinvest maturing securities, both Treasuries and MBS, and so the amount of securities that we hold will remain approximately constant. Therefore, we shouldn’t expect any major effect of that. Put another way, the amount of ease, monetary policy easing, should essentially remain constant going forward from—from June.

The Federal Reserve system is doing its part to cut the budget deficit. The central bank earned $81 billion in fiscal 2010, of which a bit more than $78 billion will be remitted to the Treasury. That’s $31 billion more than last year.

$76.2 billion in income on securities acquired through open market operations (federal agency and government-sponsored enterprise (GSE) mortgage-backed securities, U.S. Treasury securities, and GSE debt securities) [In short, the Fed is making money on its “quantitative easing” / “credit easing” activities. At least for now.];

$7.1 billion in net income from consolidated limited liability companies (LLCs), which were created in response to the financial crisis [Profits on the Maiden Lane partnerships, etc.];

$2.1 billion in interest income from credit extended to American International Group, Inc.;

$1.3 billion of dividends on preferred interests in AIA Aurora LLC and ALICO Holdings LLC [also related to AIG]; and

$0.8 billion in interest income on loans extended under the Term Asset-Backed Securities Loan Facility (TALF) and loans to depository institutions.

Additional earnings were derived primarily from revenue of $0.6 billion from the provision of priced services to depository institutions.

Those $88 billion in gross earnings were slightly offset by the following expenses:

[$4.3 billion] of operating expenses of the Reserve Banks, including $1.0 billion for Board expenditures and the cost of new currency.

The resulting $81 billion in net profits were then distributed as follows: $78.4 billion to the Treasury, $1.6 billion as dividends to member banks, and $0.6 billion retained to “equate surplus with paid-in capital.”

Here’s the simplest argument in favor of the Fed’s decision to restart quantitative easing:

The economy remains very weak. Unemployment, for example, is still almost 10%, and the underemployment rate is close to 17%.

Key inflation measures are exceptionally low. The core consumer price index (CPI), for example, is up only 0.6% over the past year.

It’s unlikely that Congress and the White House will do anything to stimulate the economy.

In short, the economy is struggling, inflation appears tame, and the Fed is the only game in (Washington) town.

Items (1) and (3) are, I suspect, not controversial. Moderate economic growth is moving us in the right direction, but has done little to create jobs or reduce the yawning output gap. And given the Republican’s election gains, it’s hard to imagine a new round of fiscal stimulus (except an extension of the expiring tax cuts — a form of anti-anti-stimulus).

Item (2), however, is highly controversial. Some commentators argue, for example, that it’s not appropriate to focus on core measures of inflation, which exclude volatile food and energy prices. Others argue that the government systematically (and, perhaps, intentionally) understates inflation.

I will leave those old debates to the side today and focus on a third, more contemporary question: Is housing messing up inflation measures?

Although the housing bubble popped several years ago, America is still adjusting to its aftermath. Falling house prices don’t directly show up in the CPI, but over time they do result in lower rents and lower estimates of the rental equivalent for owning a home. My question is how big an effect those falling housing prices are having on measured inflation.

To start, note that the core CPI really is running at exceptionally low levels:

Indeed, core inflation is well below the levels that inspired the previous round of deflation worries back in 2003.

Now let’s look at what’s happening with the shelter component of the CPI, which tracks the cost of owning or renting a home:

The CPI for shelter has fallen off a cliff. Shelter price inflation averaged about 3% from 1995 through 2007. Over the past year, however, it’s negative.

Shelter makes up almost a third of overall consumer spending, so you might expect that weak shelter prices are having a big effect on measured inflation. They do:

If you strip out shelter from the core CPI, you find that the remaining consumer prices have risen at a moderate pace over the past year (1.3%) – low, but not exceptionally low. Indeed, the economy came much closer to deflation back in 2003, by this measure, than it has so far today.

In short, the ongoing weakness in housing is a key reason why measured inflation is so low. But — and this is an important but — inflation still appears quite moderate even when you adjust for this effect. At 1.3% over the past year, the core CPI less shelter certainly doesn’t inspire concern about inflationary pressures. And if you look more recently, you find that this measure of inflation has been falling (e.g., the pace of inflation was about 1% annually over the past six months).

Bottom line: Housing weakness has indeed pushed measured inflation down a great deal, but it’s not the only factor at work.

Note 1: BLS tracks four costs of shelter: rent of primary residence (for renters), owners’ equivalent rent of residences (for homeowners), lodging away from home, and tenants and household insurance. Lodging and insurance account for only 3.5% of shelter, so it didn’t seem worth the trouble to strip them out to get a housing-only measure. You will sometimes see analysts do this comparison using the BLS measure of housing costs. Housing is about one-third larger than shelter because it includes household energy and utilities purchases, furnishings, and other household operations. For that reason, I think shelter is a better measure for exploring the relationship between the housing market and measured inflation.

Note 2: According to BLS, food comprises about 14% of consumer expenditures, energy about 9%, and shelter about 32%. So the core CPI less shelter covers about 45% of consumer expenditures. So use it with care.

When Ben Bernanke and his colleagues at the Federal Reserve announced their plan for $600 billion in new quantitative easing, I am sure they expected criticism. Angela Merkel? No surprise. Hu Jintao? Ditto. Domestic inflation hawks? Ditto again.

But could the Fed have anticipated that its most vocal critics would be a pair of talking bunnies?

If your email, Facebook, and Twitter feeds are anything like mine, you know the video: two bunny-like creatures (I’ve also heard them called smurfs and dogs) discussing “the quantitative easing” of “the Ben Bernank.” It’s hilariously effective but, as Jim Hamilton helpfully points out, also quite wrong in places.

In case you’ve missed it, here’s the video:

The folks at Xtranormal have been offering the ability to make such movies for a couple of years now, but the idea appears to have gone viral in the economics and finance space in the last week. Indeed, YouTube already has a bunch of rebuttal videos to the quantitative easing one.

So far, the funniest video I have seen (ht: Jack B) features a bunny interviewing for a Wall Street trading job. I usually keep things G-rated here, but I’ll make an exception today. Be forewarned, some of the language may be NSFW — unless, of course, you are a trader:

Economists have traditionally drawn a sharp distinction between monetary and fiscal policy. Monetary policy should try to promote growth and limit inflation by setting short-term interest rates, managing the money supply, and providing liquidity during times of financial stress. Fiscal policy should also encourage growth and, more broadly, promote the general welfare through careful choices about spending, taxes, and borrowing. The Federal Reserve has responsibility for monetary policy, while Congress and the President handle fiscal policy.

That clean distinction was one of many casualties of the financial crisis. As credit markets froze, the Fed pursued unconventional policies that blurred the line between fiscal and monetary policy. For example, it purchased more than $1 trillion in mortgage-backed securities (MBS) issued by Fannie Mae and Freddie Mac, created new lending facilities for commercial paper and asset-backed securities, and provided special support for such key financial institutions as AIG, Bank of America, and Citigroup.

Those actions differed from conventional monetary policy in two ways. First, they exposed the Fed to more financial risk. Short-term Treasury securities, the Fed’s usual fare, carry no credit risk and almost no interest rate risk. In contrast, the Fed’s new portfolio has healthy doses of both. Second, in several cases the Fed offered to purchase financial assets at above-market prices or, equivalently, to make loans at below-market interest rates. In effect, the Fed chose to subsidize some specific financial activities.

Both changes increased the Fed’s fiscal importance.

Most visibly, Fed profits have jumped as its portfolio expanded and it acquired higher-yielding assets. Indeed, the Congressional Budget Office (CBO) projects that Fed profits will hit $77 billion in 2010, up from $32 billion in 2008. That makes them the fourth largest source of federal revenues, after personal income, social insurance, and corporate income taxes, but ahead of estate and excise taxes. Actual returns could be higher or lower, however, depending on how well its investments perform.

Also important, though less visible, are subsidies implicit in some of the Fed’s financing programs. The Term Asset-Backed Securities Loan Facility (TALF), for example, offered favorable long-term funding to investors who wanted to finance investments in securities backed by auto loans, student loans, and certain other types of debt. Similar programs provided favorable funding to support commercial paper markets and to assist AIG, Bank of America, and Citigroup. CBO recently pegged the initial cost of the resulting subsidies at $21 billion.

Not all programs created subsidies, however. CBO concluded, for example, that the MBS purchase program did not involve subsidies because the Fed made its purchases at market prices.

To be sure, the Fed’s fiscal initiatives were dwarfed by the explicitly fiscal actions taken by Congress and Presidents Bush and Obama. The Troubled Asset Relief Program (TARP), for example, was originally estimated to involve subsidies of $189 billion (a figure that has fallen as financial markets have healed), and support to Fannie Mae and Freddie Mac has added tens of billions more. Still, CBO’s estimates do highlight the Fed’s move into fiscal territory as it battled the financial crisis.

Those steps were appropriate given the severity and suddenness of the crisis, but have fueled concerns about the Fed’s scope of authority. Some members of Congress, for example, have questioned whether the Fed should be able to engage in even moderate amounts of fiscal policy without congressional oversight. Their increased interest in Fed oversight, in turn, has raised concerns about defending the Fed’s traditional independence in making monetary policy.

As Chairman Ben Bernanke argued in a speech last week, maintaining the Fed’s independence in monetary policy would be easier if policymakers would “further clarify the dividing line between monetary and fiscal responsibilities.” Let’s hope such guidance comes along before the next financial crisis strikes.

This post first appeared on TaxVox, the blog of the Urban-Brookings Tax Policy Center.

As I discussed briefly yesterday, Treasury has announced plans to revitalize its Supplementary Financing Program (SFP), which will effectively mop up $200 billion in excess reserves over the next two months. Even though this is a Treasury action, it strikes me as an important step (with many yet to come) in the Fed’s exit strategy.

The boost in the SFP has created some confusion among observers, however, because of the limited information that Treasury and the Fed have provided about the rationale for the move. Indeed, as one reader pointed out to me, Ben Bernanke makes no mention of the SFP in his prepared testimony today. (Anyone know if he was asked about it in Q&A?)

Over at Econbrowser, Jim Hamilton provides an excellent summary of the SFP and the possible implications of its rebirth. He concluding thoughts:

Still, one is led to wonder whether there might be a connection between today’s announcement about the SFP and last week’s announcement of an increase in the Fed’s discount rate. Numerous Fed officials encouraged us to interpret the latter as a routine and technical management tool. Are the discount hike and SFP renewal separate and purely technical developments, or is something more involved?

If you are interested in these issues, I encourage you to read his entire post.